Things are crashing in global financial markets


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If global financial markets had a theme for 2022, it would be this: the responsibility does not stop anywhere. My adaptation stems from President Harry Truman when he said “the buck stops here”. His reference was that of political responsibility. My reference is American dollars.

The carnage has spread across bonds, stocks, currencies and now even commodities as the US dollar is the last man standing. The DXY U.S. dollar index is up more than 18% year-to-date, hitting a level of 114 not last seen in 2002. By comparison, the SPY is down 25% since the beginning of the year.

DXY Trend

Charts by TradingView

The rising dollar is a sign of tighter financial conditions and heightened stress in the global financial system. Investors are feeling the stress as the drop in market capitalization of U.S. stock and bond markets has decreased by a staggering $57.8 trillion in less than a year. As a result, markets are eagerly awaiting signs of a pivot from the Fed that would mark a turning point in monetary policy.

Reduction in the total market capitalization of US stocks and fixed income securities

The Daily Shot (used with permission)

The Fed has been clear with the markets: they will not stop until inflation is brought under control. This begs the question: but what if something breaks?

Things begin to break, creating a line of dominoes for those able to put the pieces together. Problems have arisen in Japan, the UK and Switzerland. The Fed responded by accommodating. This hosting should not be confused with dovish. On the contrary, it allows the Fed to continue its tightening.

Financial conditions are tightening

The National Financial Conditions Index has risen steadily this year and almost hit the zero limit, indicating tighter than average financial conditions. This decision signals increased tension in the financial markets due to monetary tightening by central banks.

National Financial Conditions Index
Data by YCharts

Similarly, the US Bond Market Options Volatility Index, or MOVE Index, is recording levels higher than the flash crash of 2020 and equal to levels last recorded in 2010. The pace and magnitude of this change are exceptional and suggest an increase in tensions in the bond markets. .

DISPLACEMENT Index

Charts by TradingView (adapted by the author)

One of the causes of this stress is the historical losses suffered by the bonds. Global government bonds are having their worst year of performance since the 1940s. This becomes a significant issue when market participants are trading bonds with high leverage.

Global government bonds on track for worst annual loss

The Daily Shot (used with permission)

UK saves gilts

Among those bonds that are hurting are UK gilts. The UK 30-year Gilt rate has risen more than 4% in 2022. On September 28, the Bank of England announced it was intervening in long-term UK government bonds, including this statement:

…the Bank is monitoring financial market developments very closely in light of the significant revaluation of UK and global financial assets. This revaluation has become more significant over the past day – and it particularly affects long-term UK government debt. If the dysfunction of this market were to continue or worsen, there would be a significant risk for the financial stability of the United Kingdom. This would lead to an unjustified tightening of financing conditions and a reduction in the flow of credit to the real economy.

30-year UK government bond yield

The Daily Shot (used with permission)

The Bank of England announced that it would continue this operation in the Gilts market until October 14, but it has since suggested that the intervention could continue until this deadline. The Bank has purchased over £8,761m worth of gilts to date. In addition, the BOE will adopt a temporary expanded collateral repo facility to address issues related to the shortage of liquidity in the banking system. Here is how the BOE described these repo facilities:

In connection with these transactions, the Bank will accept collateral eligible under the Sterling Monetary Framework (SMF), including index-linked gilts, as well as a wider range of collateral than normally eligible under the SMF, such as than corporate bonds.

The reason the BOE had to act this way is that falling bond values ​​threatened the solvency of liability-driven investment (LDI) funds, a component of pension funds. LDI funds are heavily invested in long-duration gilts, often with high leverage. The funds warned policymakers on September 27 that they could not maintain an orderly liquidation of assets and would be subject to insolvency.

The intervention of the BOE was necessary to avoid the collapse of the pension funds invested in the LDI. Otherwise, the BOE warned there was a “significant risk to UK financial stability” and that LDI funds were hours away from collapse. Initially, gilts rallied as rates fell in response to the announcement. But over the past few days, rates have continued to rise, leading to some of the greatest volatility in gilt markets in decades.

Chart of UK 10-year gilts

Charts by TradingView (adapted by the author)

Inflation-linked gilts

The Daily Shot (used with permission)

Japan defends the yen

Earlier in September, Japan announced it was intervening in the Forex market by buying yen for the first time in 24 years. The move comes after the yen fell sharply against the US dollar to levels not last seen in 1998, which was the last time the Bank of Japan intervened.

JPY/USD Chart

Charts by TradingView (adapted by the author)

The BOJ continues to keep interest rates very low, which contributes to the weakness of the yen. This action forces the BOJ to sell USD or USD-denominated assets and would be reviewed by the Federal Reserve. The Fed voiced support for the decision. Treasury spokesman Michael Kikukawa said:

The Bank of Japan intervened in the foreign exchange market today. We understand Japan’s action, which it believes is aimed at reducing the recent heightened volatility in the yen.

Initially, the Yen rallied on the news but has since restored the gains and is currently trading around 146-147.

The yen in the most volatile trading session

The Daily Shot (used with permission)

Credit Suisse and Swap Lines

On Oct. 3, shares of Credit Suisse (CS) depreciated 10% before recovering sharply. The move came after reports that the bank was planning to raise capital, which caused its CDS spreads reach levels never seen during the 2008 financial crisis.

In response, Komal Sri-Kumar had this to say as posted by CNBC:

I think the Federal Reserve is going to have to deal with the consequences of a credit event. Something will break. This may or may not be a Lehman moment.

A few weeks ago, CEO Ulrich Koerner wrote in a note to staff:

I know it’s not easy to stay focused among the many stories you read in the media – especially given the many factually inaccurate statements being made. That said, I hope you don’t confuse our daily stock price performance with the bank’s strong capital base and liquidity position.

But then, on Oct. 5, the Fed delivered a $3.1 billion USD swap line to the Swiss National Bank, the jurisdiction where Credit Suisse is domiciled. The swap line is the largest year to date for any counterparty and brings October’s monthly total to more than double the next highest month, and that’s only October 12th.

Central Bank liquidity swap transactions by counterparty

Chart by author (data from newyorkfed.org)

These $3 billion in swap lines are not a significant amount, historically speaking. But the rate of change deserves attention. If more swap lines are needed, this will signal that financial stress is accelerating.

One of the problems with a strong dollar is that it causes foreign central banks to sell dollar reserve assets to defend their currencies, meet financial obligations, and maintain sufficient dollar liquidity. When they sell assets denominated in US dollars, such as US Treasuries, it causes Treasury rates to rise, which further strengthens the dollar against foreign currencies. The process has the potential to feed on itself.

This is one of the reasons USD swap lines are used to provide USD liquidity to foreign central banks. Note in the chart below that 10-year Treasury rates fell during the large deployment of USD swap lines in 2009, 2012 and 2020.

Central Bank liquidity swaps

Fred

Today, foreign holdings of US Treasury securities are declining as the US dollar index rises. A similar event occurred in 2016 and 2020. I expect this decline in foreign Treasuries to put pressure on the need for additional liquidity on swap lines that may arise over the next few months.

U.S. Dollar Broad Nominal Index

Fred

Summary

I originally opened a long position in long-duration US Treasuries through TLT in August on the thesis that deteriorating economic conditions and signs of slowing inflation would encourage a recovery. This trade has been wrong so far. I continue to believe that the trade is early and I have stopped my position for the moment. The developments we discussed supported my bullish view. For example, if the amount of swap lines increases significantly, this can cause long-term rates to spike.

So far, the Fed has been dovish by supporting interventions in Japan and the UK and offering swap lines to Switzerland. I don’t think this should be interpreted as a reversal of pacifist policy. Instead, it allows the Fed to continue its tightening efforts.

On September 27, Treasury Secretary Janet Yellen said:

We haven’t seen any liquidity issues developing in the markets – we don’t see, to my knowledge, the kind of deleveraging that could mean risks to financial stability.”

I think the lines of exchange can only differ. It reminds me of something Secretary Yellen said in 2017:

Would I say there will never, ever be another financial crisis? … That would probably be going too far. But I think we’re a lot safer, and I hope not in our lifetime, and I don’t believe it will be.

Five years later, we could be working on #2.

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